5 Chapter III - Planning for Profit 32

I Table of Contents

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i Preface 1

Chapter I - Financial Analysis 2

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1.1 Financial Statements 2

1.2 Overhead Analysis 7

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1.3 Financial Ratios 9

Chapter II - Cash Planning 13

2.1 Cash Analysis ₁₃

2.2 Project Cash Flow 22

2.3 Company Cash Flow 28

2.4 Cash Flow Strategy 28

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Chapter III - Planning for Profit 32

3.1 Profit Planning 32

3.2 Profit Center Analysis 34

3.3 Breakeven Analysis 37

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Chapter IV - Financial Planning 40

4.1 Investment Decisions 40

4.2 _{Financing for Growth 42}

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Chapter V - Application 46

5.1 Ryland Group Inc. 47

5.2 Morrison Knudson Corp. 60

Accesion For

NReferences TIS CRA&I 74

DTIC TAB Unannounced 5 Justification- . By ... I ~Distribution Availability Codes I 'Avai ad / or Dist Sipecial

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PREFACE

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The scope of this paper is to discuss the financial management of a construction contractor. This paper

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attempts to approach this subject in a logical and

systematic way. It communicates the importance of financial analysis and planning along with cash planning and profit - planning. This report is not intended to be an all

inclusive discussion of financial management in

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construction.

Contractor's Financial Management is an extremely

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important subject. It has been told that a large percentage

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of bankrupt contractors were profitable at the time of their failure, but due to their poor financial management failure

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resulted. Good financial management looks at past history of the company as well as planning for its future.

* Management needs to understand the basics of why they are making or losing money.

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CHAPTER I

IFINANCIAL

ANALYSIS

1.1 FINANCIAL STATEMENTS

The financial statements are the basic measurements of a companies strengths and weaknesses. Poor financial

management is the prime rebL.., v -. contractor's fail. It is difficult to stay in business withc-it keeping score.

Financial statements, Income Statements, and Balance Sheets are the basis for keeping score of sales, profit and loss. The most successful companies execute financial state1vents on a monthly basis.

The Income Statement is the contractors primary

financial management tool. Sometimes called the Profit and Loss statement, it shows the contractors profit and loss over a period of time. It is the key to understanding a companies operations. The Income statement is a summary of the Net Sales, Direct Costs of Sales, Operating Expenses, and Profit of the company. It should be performed on a monthly basis (2:1-4).

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Terms used in an Income Statement:

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N - The dollar volume of business transacted for

-- the period.

2. Cost of Construction - The cost of all contracts or

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services sold during the period. These costs are directly related to a project.

3. Gross Profit - Net Sales minus Cost of Construction. This is the total income prior to the subtraction of

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Operating Expenses.

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4. Operating Expenses - Total expenses for during business but not chargeable to Cost of Construction.

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5. Variable Overhead - Operating Expenses that are a function of the amount of Cost of Construction.

6. Fixed Overhead - Operating Expenses that do not vary

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with Cost of Construction. It is necessary regardless of

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the amount of business.

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7. Net Profit Before Tax - The difference of Gross Profit minus Total Overhead.

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8. Net Profit - Income earned as profit after taxes.

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BALD EAGLE CONSTRUCTION

INCOME STATEMENT 1993 1992 SALES $4.189.560 100.00% $6.651.400 100.00% COST OF SALES MATERIAL $1.177.266 28.10% $1.130.738 17.00% LABOR $1,483,104 35.40% $1,197.252 18.00% SUBCONTRACTS $837,912 20.00% $3.192.672 48.00% OTHER DIRECT COST $6.284 0.15% $109.748 1.65% TOTAL DIRECT COST $3,504.567 83.65% $5.630.410 84.65% GROSS PROFIT $684,993 16.35% $1.020.990 15.35% GENERAL EXPENSES

VARIALBLE OVERHEAD

DEPRECIATION $250.000 5.97% $250.000 3.76% CONST. EQUIPMENT REPAIRS $62.843 1.50% $99.771 1.50%

INTEREST $4,190 0.10% $6.651 0.10% LEGAL EXPENSES $3,142 0.08% $4,989 0.08% BAD DEBT $3.771 0.09% $5.986 0.09% WARRANTY COST $12,569 0.30% $19.954 0.30% OFFICE SUPPUES $1,676 0.04% $2,661 0.04% COMMUNICATIONS $1.257 0.03% $1.995 0.03% TOTAL VARIABLE OVERHEAD $339.447 8.10% $392,007 5.89% FIXED OVERHEAD OFFICERS SALARY $256,100 6.11% $256.100 3.65% OFFICE STAFF $97.410 2.33% $97,410 1.48% RENT $17.200 0.41% $17,200 0.26% INSURANCE $53,500 1.28% $53.500 0.80% ACCOUNTING $14,800 0.35% $14.800 0.22% OFFICE UTILITIES $15900 0.38% $15,900 0.24% DUES $2.000 0.05% $2.000 0.03% TOTAL FIXED OVERHEAD $456.910 10.91% $456,910 6.87% TOTAL OVERHEAD $796,357 19.01% $848,917 12.76% NET PROFIT BEFORE TAXES ($111.264) -2.66% $172,073 2.59% INCOME TAXES $0 $55,063

NET PROFIT AFTER TAXES ($111,364) $117.009

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The management of resources begin with the analysis of the Balance Sheet. The Balance Sheet is a statement of the company's financial position at a specific time. Assets are placed on the top while Liabilities and Net Worth are placed

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on the bottom of the sheet. The total of Assets must equal

Liabilities plus Net Worth (2:1-7).

Terms used in a Balance Sheet

1. Assets - Something of value owned by the company

2. Current Assets - Assets that can be liquidated into cash within one year.

3. Fixed Assets - Assets that cannot be liquidated into cash in one year.

4. Total Assets - Current Assets plus Fixed Assets.

5. Liabilities - Amounts owed to others by the company.

6. Current Liabilities - Amount due within one year. 7. Long-Term Liabilities - Amount owed past a year.

8. Total Liabilities - Current Liabilities plus Long-Term Liabilities.

9. Net - Total Assets minus Total Liabilities.

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13BALD EAGLE CONSTRUCTION BALANCE SHEET

IASSETS

1993 1992 CURRENT ASSETS Cash $55,700 $85,100 Accounts Receivable $908,023 $515.700 Material inventory $25,700 $15.700 Notes Receivable so $0

Cost in Excess of Billings

and Estimated Earnings $0 $25,100 Prepaid Expenses $32.000 $23.600 Other Current Assets $10.200 $7,000 Total Current Assets $1,031.623 $672.200

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FIXED ASSETS

Total Fixed Assets $550,000 $700,000

Less Accumulated Depreciation $250,000 $250,000

Net Fixed Assets $300,000 $450.000

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TOTAL ASSETS $1,331.623 $1.122,200

IABILTIES

CURRENT UABILITES

Aount Payable $871.487 $505.200

Notes Pay"le $40,000 $15,000 Bings and Estimated Earnings

In excmss of cost $42.500 $45,900

Aoorued Expense. $15,800 $12,900

Other Current Uablbs $10,000 $8,000

Total Current ibilities $079,787 $587,000

ILONG

TERM UABILITES

Morgagee $190,000 $202.000 Equipment Fhnacg $25,000 $85,000

Other Long Term Liabilities _$0 Total Long Term Liabilities $215.000 $287.000 TOTAL LIABILITIES $1,194,787 $874,000

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NET WORTH

Capital Stock $100,000 $100,000 Retained Earnings Jan. 1 $148,200 $231.191

Net Income for Year ($111,364) $117,009

Len Dividends _{$0 ($200,000)}

Total Retained Earnings $36.836 $148,200 TOTAL NET WORTH $138,836 $248,200

STOTAL

LIABILITIES AND NET WORTH $1931.623 $1,122.200

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1.2 OVERHEAD ANALYSIS

A company must properly identify and allocate their

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overhead costs. These costs must be identified and

separated as fixed or variable costs.

Fixed costs are those costs essential to remain in business. They are not related to the volume of sales.

Variable costs are those costs which are related to the i volume of sales. Variable costs rise with an increase in

sales.

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Proper allocation of overhead allows for accurate bidding, control during construction and as a contribution

toward profits. Tn the construction industry, unlike the manufacturing industry, more than 50% of Costs of Sales are variable costs. Therefore increased profits can rarely be

obtained by increases in by volume alone. Profits are made by increasing productivity and decreasing overhead (2:2-8).

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EXAMPLE VARIABLE AND FIXED COSTS Variable costs: Advertising Auto Bad Debt

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Employee Benefits Entertainment Interest Office supplies Taxes Telephone Travel Warranties Fixed Costs: Contributions Depreciation Insurance Payroll Taxes Rent Repairs Salaries Utilities

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1.3 FINANCIAL RATIOS

After the monthly financial statements are completed, a financial analysis by ratios can be performed. The

contractor will need to use the Balance Sheet to calculate these ratios in deterrining the performance of the company.

1.3.1 ACID TEST OR QUICK RATIO

Acid Test = (Cash+Accts Receivable) / Current Liabilities

This ratio measures the ability of a firm to cover its

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Current Liabilities by using its Cash and Accounts

Receivable without converting Inventory or Other Current Assets to Cash. This ratio should be in the range of 1.0 -1.5 to 1. An Acid Test Ratio less than 1.0 to 1 will not be

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able to meet current obligations as they become due without converting Inventory or Other Current Assets into Cash or financing through Long-Term Debt. An Acid Test Ratio

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greater than 1.5 to 1 indicates the company is

overcapitalized and should consider investing the excess in other profit producing ventures or attempt to maximize cash turnover through an increased sales volume (2:4-3).

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1.3.2 CURRENT RATIO

Current Ratio = Current Assets / Current Liabilities

This ratio is used to determine the number of times Currp-t Liabilities can be paid by Current Assets. A range of 1.5 - 2.0 to 1 is recommended. A Current Ratio less than

1.5 to 1 the company may not be able to meet its current obligations. I 2urrent Ratio higher than 2.0 to 1 the company has excellent financial strength but may be

stagnant. It should use this excess of Current Assets in other profit generating investments.

1.3.3 CURRENT LIABILITIES TO NET WORTH Current Liabilities / Net Worth = Index of Debt

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This ratio compares what a company owns to what it owes. Any percentage over 80% indicates to much debt to

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creditors.

1.3.4 CURRENT ASSETS TO TOTAL ASSETS

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Current Assets / Total Assets = Index of Liquidity I

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This ratio is used to measure the relative liquidity of

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a company. An acceptable range is from 0.60 - 0.80 to 1. A

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ratio less than 0.60 to 1 may indicate an excessively high investment in fixed assets. A ratio greater than 0.80 to 1

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may indicate that the company has not invested heavily into

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fixed assets such as equipment and vehicles.

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1.3.5 WORKING CAPITAL

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IWorking Capital = Current Assets - Current Liabilities

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Working Capital is a measure of funds available for

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future operations.

1.3.6 DEBT TO EQUITY RATIO

Total Liabilities / Total Net Worth = Degree of

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investment

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This ratio indicates creditors investments to owners

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investments. The ideal range is 1.0 - 2.0 to 1. If the ratio is less than 1.0 to 1, it suggests a strong equity position for the company but lacking in debt financing to

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its advantage. A ratio greater than 2.0 to 1 shows that

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creditors have more than twice the amount invested in the company as do the owners. This may be excessive.

1.3.7 DEGREE OF FIXED ASSETS NEWNESS

Degree of Fixed Assets = Net Depreciable Fixed Assets

Newness Total Depreciable Fixed Assets

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This ratio measures the proportion of the original cost

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of Fixed Assets which have not been depreciated. The

desirable range for this ratio is 40% to 60%. If the ratio is less than 40% than the company is probably using an old

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equipment fleet. A ratio greater than 60% may suggests the

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company is young or the equipment has been recently updated to improve productivity or to take on new business.

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CHAPTER II CASH PLANNING

Projecting cash flow is an important aspect of

contractor financial management. A cash flow forecast is a projection of the cash receipts and cash payments for a

future period of time. A companies cash supply is

determined by its profitability and efficiency. Failure to have an adequate cash flow has resulted in the bankruptcy of many otherwise profitable companies. To ensure the company

has a proper cash flow, a cash analysis must first be preformed (3:101).

2.1 CASH ANALYSIS

This analysis is done by computing the following (2:5-2):

- Cash Conversion Period - Accounts Payable Period - Cash Demand Period

- Working Capital

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I2.1.1

CSH

CONVERSION PERIOD

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The Cash Conversion Period is the average time the

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companies cash moves through the cash cycle back to the company. This time consists of the summation of the following:

- Average Age of Accounts Receivable

- Average Age of Retainage

- Average Age of Inventory

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-Average Age of Work in Progress

The average Cash Conversion Period should not exceed 75 days. If it does exceed this amount of time than the

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company is probably doing a poor job in its collections which results in an excessive amount of borrowing.

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2. 1. _{la AVERAGE AGE OF ACCOUNTS RECEIVABLE}

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The Average Age _{of Accounts Receivable is the time}

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it takes from billing to receipt of payment. The Net Sales will come from the company Income Statement and the Average

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Accounts Receivable from the Balance Sheet.

Average Age of = Average Accounts Receivable X 365

Accounts Receivable Net Sales

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An age over 45 days shows a serious problem with the

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companies collections.

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2.1.1b AVERAGE AGE OF RETAINAGE

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The monthly Income Statement and Balance Sheet is

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also used for this equation. The Average Age of Retainage is the average length of time the cash is tied up in owner's

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I Average Age of Retainage =Average Retainacte X 365

I Net Sales

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The average age should not be more than the contract allows.

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2.1.ic AVERAGE AGE OF INVENTORY

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This is the length of time that cash is tied up in inventory. This calculation is made by using the monthly

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average material inventory from the Balance Sheet and the

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materials cost from the Income Statement.

Average Age of Materials = Average Materials Inventory X 365

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Average Materials Cost

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This age should not be more than 30 days. If it exceeds 30

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days than the company may _{have to much cash invested in}

* inventory.

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2.1.1d AVERAGE AGE OF WORK IN PROGRESS

£

The Average Age of Work in Progress is the time

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that cash is tied up in unbilled work.

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Average Age of = Costs and Estimated Earnings in Excess of Billings X 365 Work in Net Sales

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Progress

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This amount of time represents work in the ground

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that has not been billed for on the last progress payment.

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The company should do its utmost to keep this to a minimal.

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2.1.2 ACCOUNTS PAYABLE PERIOD

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This is the length of time the company takes to pay its

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bills. It is the time from billing to payment. This time consists of the sunmation of the following:

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- Average Age of Accounts Payable

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- Average Age of Billings in Excess of Costs and Estimated Earnings

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2.1.2a AVERAGE AGE OF ACCOUNTS PAYABLE

This is the average length of time the company

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takes to pay bills. Materials and Subcontracts costs are

taken from the monthly Income Statement.

Average Age of Accounts = Averaae Accounts Payable X 365

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Payable Materials + Subcontracts

The industry norm is considered 45 days. More

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than 45 days will prevent the company from taking advantage

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of cash discounts and may harm its credit rating.

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2.1.2b AVERAGE AGE OF BILLINGS IN EXCESS OF COSTS

AND ESTIMATED EARNINGS

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This shows the average time for which billings

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have been made, but which the costs are less than the

billings made.

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Average Age of = Average Billings in Excess of Costs X 365

Billings in Net Sales

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Excess of Costs

and Earnings

i The Average Age of Billing in Excess of Costs and

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Earnings should be zero. The average of 5 days is sometimes

accepted as the upper limit. Anything more represents payment for a weeks work that must be completed in the

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future.

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2.1.3 CASH DEMAND PERIOD

The Cash Demand Period is the average number of days that

the company will need funds to meet current obligations.

Cash Conversion Period

Accounts Payable Period

Cash Demand Period

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As shown in section 2.1.2, the Accounts Payable Period

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is the summation of Average Age of Billings in Excess of Costs and Average Age of Accounts Payable. This Cash Demand

Period will vary depending on the effectiveness of

collecting Accounts Receivable and inventory management as

explained in section 2.1.1. The industry average is 30

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days. The most successful companies have a short Cash

Conversion Period as well as a short Accounts Payable

* Period.

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2.1.4 WORKING CAPITAL

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Working Capital is the difference of Current Liabilities

from Current Assets and represents the contractor's capital

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resou rces to generate new business. Working Capital

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ratios indicate the company's general financial health

regarding cash and its use.

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2.1.4a WORKING CAPITAL TURNOVER

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This ratio indicates the degree to which Working

Capital is used versus credit.

__" I Working Capital Turnover = oknNet Salescaia

If this ratio is to high then the company owes too

_ much or is doing too much work, resulting in credit being

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substituted for adequate use of Working Capital Turnover.

If the ratio is too low then borrowing is rarely used.

"U _{Most profitable contractors have a Working Capital Turnover}

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between 8 and 12 times per year.

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"I 2.1.4b RETURN ON WORKING CAPITAL

* _{The Return on Working Capital is a percentage that}

measures the company's freedom to do business. This ratio is important because capital is usually provided by

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borrowing or through sales volume. If a change occurs the company may be unable to borrow, conduct daily operations, or required to change its prices.

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Return on Working Capital = Net Profit

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n k C a Working Capital

The suggested range for Return on Working Capital is between 40 to 60 percent.

-- 2.1.4c OWNER'S INVESTMENT TO CREDITOR'S INTEREST

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This ratio is another index of a contractors

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liquidity. It measures the owner's investment to the creditor's interest.

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Owner's Investment to = Working Capital

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Creditor's Interest Current Liabilities

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This ratio should be 0.80 - 1.0 to 1. If the

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ratio is less than 0.80 the company may have a problem with

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liquidity. Greater than 1.0, the company may be

overcapitalized and should consider investing the excess in other profit producing ventures or attempt to maximize cash

-* turnover through an increased sales volume.

2.1.4d WORKING CAPITAL TO FUNDED DEBT

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This ratio indicates the degree of debt, the ability to pay and the dependency on borrowing.

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IIndex of Meeting Obligations = Working Capital Funded Debt

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The acceptable percentage is a matter of judgement. In bad economic times a lower percentage is utilized while in good

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times a higher percentage is used. This ratio should

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approximate the Acid Test Ratio.

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2.2 PROJECT BUDGET AND CASH FLOW

As shown in the previous section, Cash Analysis

provides much planning information. However, it does not

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provide for long term cash needs. This long term need is

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provided by proper Cash Flow Planning. But before Cash Flow

can be projected, a Budget projection must be performed.

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2.2.1 BUDGET PROJECTION

* A projects budget provides a monthly snapshot of all cash outlays and income. It is a numerical plan of

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operations and a predictor of the company's performance. It

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also identifies the anticipated sales, costs and profits of

the company. The operating budget provides three primary

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benefits (1:93):

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- It identifies the relationship between sales, costs,

* _{and profit that a company anticipates during a period}

of operation.

S- It provides a numerical basis by which alternative

* business decisions can be measured before they are

made.

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The operating budget helps control overhead.

The following are basic steps to developing a budget (1:99):

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- Establish the desired Rate of Return on Investment, and -- define the dollar amount of Net Profit needed to

achieve that Rate of Return.

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- Estimate all costs, Fixed and Variable.

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- Add the necessary Net Profit to your estimate for Fixed Overhead to determine the amount of dollars which must

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remain after all Variable Costs are paid.

- Divide Net Profit plus Fixed Overhead by the Marginal Ratio to identify the necessary level of Sales.

Marginal Ratio = 100t - (Total Direct and Variable

* Costs as a % of Sales)

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- If the results are reasonable, complete the budget. If not then redefine your Return on Investment objective

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or reestimate costs for the sales volume indicated,

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then proceed through the steps again.

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Successful companies prepare monthly budgets as well as

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annual budgets. Once the budget is complete, adopt it and

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work towards accomplishing it. Remember, no matter how good your budget is, it is of little value unless you use it to evaluate your month to month performance in an effort to

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make your actual Income Statement meet the forecasted

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results. Everyday the company should use this budget in its

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operational decisions. By using budget information, companies are able to improve their decision making

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abilities and enhance its profits.

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EXAMPLE BUDGET FO %oT_{% of}

NET SALES $ Amount Sales

COST OF SALES:

Materials Labor

Subcontracts

Other Direct Costs Total Direct Costs

OPERATING EXPENSES: VARIABLE OVERHEAD

Advertising

Auto and Truck Expense

Bad Debts Communication Interest Miscellaneous Office Supplies Taxes

Travel and Entertainment

Unapplied Labor (Includes Payroll

Taxes and Union Fringes) Warranty Costs

Total Variable Overhead

FIXED OVERHEAD

Contributions

Depreciation

Dues and Subscriptions

Insurance

* Legal and Audit

Payroll Taxes (Office Only)

Rent

Repairs and Maintenance

Salaries - Officers Salaries - Office

Salaries - Engr., Est., Sales

Salaries - supervision

Shop Supplies and Tools Utilities

Total Fixed Overhead TOTAL OVERHEAD

NET PROFIT BEFORE INCOME TAX

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2.2.2 CASH FLOW

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Now that a budget has been done, a Cash Flow can be preformed. A Cash Flow is a projection of the cash receipts a-.d cash payments for a future period of time. Without this

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projection a company can easily get behind in paying their

subcontractors and suppliers due to late payment from the owner or the improper allocation of payment monies received by the contractor. Lack of adequate capital or operating reserves can also contribute to the contractor's inability to pay subcontractors and suppliers (3:101).

Good construction financial management should result in

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a positive Cash Flow which allows the contractor to avoid or

minimize borrowing. A positive Cash Flow also allows the contractor to take advantage of supplier discounts for early payment.

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!2 c -0 to 4 4* 494 V r-( 449

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4494049 _{40 49 49} Od 49

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4.N-6 CD 49 V-V~ UO. ýj if _{P 1} Im _{C' z- 0}

-w.

-0,;

3

0 94949

3

0) 449

ot

94 UU 0*4u9U ; ~WO w i co U*. 0 9 4949 L co qu L! 0 t- 2

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2.3 COMPANY CASH FLOW

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The Company Cash Flow is the combination of cash flows from all current and expected projects and all operating expenses. The Company Cash Flow Budget is prepared for 12

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months in advance and revised monthly. It will show the

flow of cash into and out of the company. Excessive amounts of cash into the company means cash is not working and not yielding a Return on Investment. While a lack of cash means creditor problems, excessive borrowing, and failure to pay bills and loans on time (2:7-2).

From the Company Cash Flow we can develop the projected i Income Statement and Balance Sheet. Once these are

projected the company can analyze their Financial Ratios, borrowing requirements, and expected Profit.

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2.4 CASH FLOW STRATEGY

The company must plan for the short and long term management of the company's cash. Borrowing is not always

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the answer because it is expensive. Cash Flow Strategy is

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concerned with increasing liquidity. They deal with early

payment of cash to the company, cash reserve investment, and

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delayed payment of obligations (2:8-2).

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2.4.1 EARLY PAYMENT

- Unbalanced Bids - The objective is to accelerate

payment at the early stages of construction. Unbalanced bid items include salaries, mobilization, materials purchases,

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equipment leasing, and initial earth or foundation work.

* This can also be used in unit price contracting by high pricing of early construction items and high pricing of

items expected to increase in quantity. Remember large

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early payouts mean lower payments as the work progresses.

* This may result in the need for borrowing when cash income decreases.

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- Progress Payments - Ensure the owner does not

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delay Progress Payments. Delay of payment forces the

contractor to borrow and to include interest in his bid. Methods to reduce the time of payment include:

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1) Come to agreement that the owner pays within a

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certain amount of time from receipt of request for

payment.

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2) Atree to the amount of retainage and when it will

* be paid.

3) Set your bank account for the project at the owner's

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bank so progress payments are make more quickly.

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4) Submit bills on time or more frequently.

5) Pass all bills directly to the owner or bank for

* payment.

6) Increase work in place to accelerate payment, lower

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cash flow requirements, and accelerate retainage

payment.

2.4.2 CASH RESERVE INVESTMENT

Investing Cash Reserves is also an effective method of increasing Cash Flow. These include Discounts and Short

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Term Investments.

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- t - These are based on early payment and

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represent a reduction in accounts payable. The current rate of interest is the determining factor in taking a Discount. Discounts less than the annual borrowing rate should not be

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taken. If the discount is more than the current cost of

* money then take the discount.

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- Short Term Investment - Excess cash should be * deposited in interest producing accounts such as:

U.S. Treasury bills Lending securities Certificates of deposit Commercial paper

Money market funds

Excess cash should never be left idle in noninterest accounts. Additionally, cash should be readily available

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for fluctuating demands on cash.

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2.4.3 DELAY PAYMENT

Delaying Payments are another method of increasing Cash Flow. This can be done by:

- Delaving payment of bills - This very popular but

i could result in reduced credit from suppliers, bad

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credit rating, lost discounts, and bad relations. Buy materials when they are needed thus reducing

inventory.

- Include retention in subcontractor agreements

including payment when the Company's progress payments are met.

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CHAPTER III PROFIT PLANNING

The profitability of a company is a driving factor for I _{investors and lending institutions. Profits are used as a}

gauge in comparing year to year performance as well as

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comparison to competing companies. This chapter explains

how to analyze and increase profits.

3.1 PROFIT PLANNING

We plan for profit to maximize them. There are three

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ways to increase profits: Increase volume, Increase gross

margin, and Control of overhead.

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3.1.1 INCREASE VOLUME

Increasing Sales is not the most effective method to

increase profits, however it is the most often used. A

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company can increase sales by (2:9-3):

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Lower bid pricing

- Increased bidding

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- Increased marketing I - Diversification

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Gross Profit Margins are controlled. 3.1.2 INCREASE GROSS MARGIN

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Gross Profit Margin is the ratio of Gross Profits to

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ISales. _{Checking Profit Margins from the Income Statement is} an excellent way for companies to oversee their goal of

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meeting profits (2:9-6).

Gross Profit Margin= Gross Profit Net Sales

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Gross Margin is increased by:

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- Reducing Variable Costs - Variable costs account for

over 50% of Gross Costs. Reducing this cost is the most effective means to increase net profits.

- Improvements in Productivity - This is the most

3

effective way to increase gross profits. This is done by controlling labor and material costs.

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Negotiate Contracts - Competitive bidding reduces

3

Profit Margins. Negotiated work allows for better pricing and profit margins.

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In

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3.1.3 CONTROL OVERHEAD

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Overhead must be classified as either fixed or

variable. In reducing overhead, Fixed overhead may not be reducible unlike Variable overhead. Overhead is controlled

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by comparing overhead costs as a percentage to other costs.

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This is done by the following overhead ratios:

- Total Overhead / Net Sales

- Total Overhead / Total Direct Costs

- Total Overhead Labor Costs - Total Overhead / Material Costs

Income statements should show the percentage of overhead per category. They should be reviewed monthly. The lower the percentage of overhead the higher the profits.

3.2 PROFIT CENTER ANALYSIS

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Profit Center Analysis is concerned with looking at

3

each project or similar types of projects in their

contribution to the company's total sales. It helps to determine which projects are profitable and which are not.

3

By knowing this the company is better able to do short and

3

long term planning.

Profit Center Analysis analyzes the contribution to

* profit and overhead by the individual project or profit

centers. Profit Center Analysis is dependent on the

accuracy with which the various components of the Income Statement are allocated or distributed to the various profit

centers.

3

When Net Sales and Direct Costs are distributed to the

5

various profit centers, Gross Profit is determined for each

of the centers. Now Operating Expenses of the total company

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must be distributed as equitably as possible to each of the

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profit centers (1:178).

Only after this can one determine whether a particular type of work or project is profitable. Operating Expenses

3

are distributed to the various profit centers by the

i following: - Percentage of Sales

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-Percentage of Labor S- Percentage of Material - Management Judgement

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EXAMPLE COMPANY BUDGET

Total Proj Proj Proj

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¢

--v

A

B

C

Net Sales $1,118,000 325,000 520,000 273,000 Cost of Sales Materials 479,570 169,520 224,700 85,350

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Labor 274,890 60,580 123,525 90,785 Subcontracts 29,345 11,245 18,100

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Other direct Costs 10.818 3.803 4,575 2,440

Total Cost of Sales 794.623 245,148 370.900 178,575

5

Gross Profit 323,377 79,852 149,100 94,425

Overhead Expenses

Variable Overhead 65,057 18,297 28,814 17,946

Fixed Overhead 173.600 33.157 93.925 46.518

Total Overhead 238,657 51,454 122,739 64,464 Net Profit before Taxes $ 84.720 28.398 26.36i 29.961

3

Net Profit to Sales 7.57% 8.74% 5.07% 10.98%

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3.3 Breakeven Analysis

A Breakeven Analysis determines the breakeven point in sales, sales required for a given profit and the effects price and cost changes has on profits.

3.1.1 BREAKEVEN POINT

i The breakeven point is very important because it is where profit begins. At the breakeven point:

Profit = 0

Net Sales = Variable Costs + Fixed cost

I The Breakeven point is calculated as:

3

Breakeven Point = Fixed Costs / Marginal Ratio

Marginal Ratio = 100% - Variable Cost as a % of Sales

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Breakeven Analysis shows where Net Sales equals

- Overhead. Every manager should know their breakeven point for the company and its projects. With the above equation,

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the Breakeven sales volume can be calculated for a desired

5

Marginal Ratio and known Overhead Costs.

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3.3.2 PROFIT AS A PERCENT OF SALES

Sales = Fixed Overhead / (Marginal Ratio - Profit)%

This equation enables you to find the sales volume needed to generate a certain dollar amount of profit.

3.3,3 PRICE CHANGES

To increase Profit, Net Sales must increase. This can

be done by increasing the volume of sales or increasing sale prices. Increcsing sales volume increases Variable Costs.

Increasing sale prices is much more effective in realizing your profit goals because the volume of work remains

unchanged as do variable costs.

3.3.4 FIXED COSTS AND PROFITS

-- Increases in Fixed Costs have a dramatic effect upon

Net Profit. As Fixed Costs increase and the Marginal Ratio

£

remains the same, the Breakeven Point increases and Profits

3

decrease. The Breakeven Point increases by a multiple of

the increase in fixed costs. This multiple is the inverse of the Marginal Ratio (1:169).

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3.3.5 VARIABLE COSTS AND PROFITS

Changes in Variable Costs have a greater effect on the Breakeven Point and Profits than does a change in sales volume. An increase in Variable Costs without an >icrease

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in Net Sales reduces your Margin Ratio. This results in reduced profits and a greater Breakeven Point. The opposite

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is true of reducing your Variable Costs.

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CHAPTER IV FINANCIAL PLANNING

Companies that plan for the future consistently do well

financially. Making good investment decisions and financing

for growth are two requirements for Financial Planning.

4.1 INVESTMENT DECISIONS

Investment decisions are broken down into long-range

and short-range decisions.

4.1.1 LONG RANGE DECISIONS

This depends on three decision making factors. They

are Return on Investment, Degree of Risk, and Payback.

4.1.1a RE71W ON INVESTMENT

This measures the return the investment will yield

in addition to returning the original expenditure.

Return on Investment=Net Profit before Taxes / NetInvestment

Return on Investment is used to analyze projects

having similar economic lives and whose patterns of Net

Investment are very similar.

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4.1.1b DEGREE OF RISK

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Risk is difficult to measure. It requires a subjective valuation. You can expect greater returns as more risk is taken on (1:135).

4.1.1c PAYBACK

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The time required to recover the original

3

investment. When considering similar types of investments, chose the one with the shortest payback period. The shorter one uses the least amount of Working Capital for the

3

shortest period of time. This frees up Working Capital for

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other investments.

3

4.1.2 SHORT RANGE DECISIONS

Company annual budgets are used for short-ranged decisions. Once the budget is completed along with the profit objectives, ways must be found to meet these goals.

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These goals are met by bidding on upcoming projects. The criteria in selecting these projects are similar to those

B

used in Long-Range Decision making.

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4.2 FINANCING FOR GROWTH

3

Many companies fail because they lack the capital to meet current obligations. Of these failed businesses, a good percentage were profitable at the time of failure. The

3

major reasons for failure in the construction industry is

5

poor management and the inability to obtain adequate financing. A company can overcome these deficiencies

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(1:145).

4.2.1 ESTABLISHING A LINE OF CREDIT

* _{This is an agreement in which the lender declares its}

3

Iintent _{to extend a certain amount of money to a company.} It is a commitment by the lender to make a loan when required by the company. This requires planning to determine its

5

Line of Credit needs. The annual budget is the plan used to

3

determine this need. Make every effort possible to receive the most favorable agreement. This includes favorable

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interest terms and also the conditions of the agreement.

1

4.2.2 SELECTING YOUR BANKER

3

Find a bank that can service all your needs. This means one that is able to handle your maximum requirements.

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You should also know the lending policies of the bank.

3

Choose a bank that understands the construction business. And finally consider the safety of the bank.

3

4.2.3 PRESENTING THE COMPANY IN ITS BEST LIGHT

When establishing a Line of Credit present yourself in

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a professional manner. Present the facts and provide the

g

information required by the banker in a timely manner. This information most likely includes:

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- History of the company

S-

Organization structure

- Company's management information system

- Financial history

- Current year's operation

- Work in progress

S-

List of references

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4.2.4 WHAT THE BANKER WANTS TO KNOW

The banker may ask questions about how you do business and the internal workings of the company. They may ask

£

questions such as:

- Is backup management sufficient?

- How will the money borrowed by used?

- When will you repay and where will the funds come from?

- What are your sales and profit trends?

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These are a few of the potential questions. The banker

3

is most interested in your financial standing. The results of the analysis performed on your Financial Statements will have a major impact in the banks decision. This analysis

3

will include:

- Current Ratio - Acid Test Ratio

- Working Capital

- Working Capital Turnover

- Net Profit divided by Net Sales

- Net Profit divided by Working Capital - Debt to Equity Ratio

- Average Age of Accounts Receivable

- Cash Conversion Period - Cash Demand Period

4.2.5 MAINTAINING YOUR LINE OF CREDIT

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Once your Line of Credit is established do the utmost to maintain the relationship with your banker. The bank

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will hold its part of the agreement and so must you. Make

3

good on all commitments and never exceed the Line of Credit. Exceeding your Line of Credit shows poor management and may result in the cancellation of the agreement. You should

3

also periodically review your Line of Credit needs. This shows the banker that you are managing your business.

You must also maintain or increase profits less your

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Line of Credit be reduced or cancelled. In addition, avoid

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decreases in liquidity and new loans without your bankers

3

approval. _{These may seriously effect your ability to repay} the loan and may result in reduction or cancellation of your Letter of Credit (1:153).

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CHAPTER V APPLICATIONS

I have selected two well known companies to apply the information in this report. One company, Morrison Knudson is a highly diversified international construction company. While Ryland is the nation's third largest homebuilder and a leading mortgage-finance company.

The application of the information in this report would

be ideal for a small construction company. Unfortunately, I was unable to access the finances of any local contractor.

This information is difficult to obtain and any interest in it is subject to suspicion by the contractor.

5.1 The Ryland Group Inc.

3

Business: Ryland is a leading national homebuilder and a mortgage-related financial services firm. Established in 1967, the company currently builds homes and provides

3

mortgage services in 18 states. The company was the third

3

largest single-family on-site homebuilder in the United States in 1993 based upon homes delivered. The company's homebuilding segment specializes in the sale and

3

construction of single-family attached and detached housing

and condominiums. The financial services segment provides mortgage-related products and services for retail and

3

institutional customers and conducts investment activities.

3

The company facilitates the issuance of mortgage-backed securities and mortgage-participation securities through its

3

limited-purpose subsidiaries.

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Financial Analysis

Because of Ryland's diversification, an acceptable

3

limit on the ratios was not found. However, looking year to

3

year we are able to analyze general trends.

3

LIQUIDITY RATIOS Test/Year 1991 1992 1993 Acid Test 0.04 0.05 0.37

3

Current Ratio 4.31 2.30 4.88 Debt/Equity 8.48 6.90

*

.ratio Current 39V 751 401 Liab/Net Worth

5

a) The acid test shows the number of dollars of liquid assets available to cover each dollar of current debt.

Anytime this ratio is as much as 1 to 1 the business is said

5

to be in a liquid condition. The larger the ratio the greater the liquidity. As shown above, Ryland in 1991 and 1992 had virtually no liquidity. In 1993, liquidity

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improved to .37 and should increase with greater home sales.

3

b) _{The current ratio measures the degree to which current}

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assets cover current liabilities. The higher the ratio the

* more assurance exists that the retirement of current

liabilities can be made. As shown, Ryland's current ratio is very high. This is due in part to its large inventory it

* carries.

c) Debt to equity ratio shows as of 1993 creditors funding is nearly 7 times that of the owners equity. This may be

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excessive, especially if the company is burdened with

substantial interest charges.

d) The current liabilities to net worth ratio shows a decrease to 40% in 1993. This appears to be a reasonable

3

Ipercentage. The smaller the net worth and the larger the

3

liabilities, the less security for the creditors.

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Conclusion: It is obvious from the above ratios that Ryland

3

is illiquid and is carrying a large inventory. Increasing

home sales and using inventory should have a significant impact on improving Ryland's liquidity.

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Cash Analysis

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EFFICIENCY RATIOS

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Test/Yr 1991 1992 1993

Avg age of Accts 0 days 0 days 0 days

i Receivable

Sales to Inventory 2.43 2.22 2.46

Accounts Payable 7% 5% 5%

to Sales

a) The company's average age of receivables is

3

insignificant. This is due to selling and financing of the

3

homes by Ryland.

b) The sales to inventory ratio is a guide to the rapidity

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at which inventory is being moved and the effect on the flow

3

of funds into the business. As shown, the ratio is relatively small indicating the company has a very high inventory or slower moving inventory.

I c) Accounts payable to sales measures how the company is I paying its suppliers in relation to the volume being

transacted. An increasing percentage or one larger than the

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industry norm, indicates the firm may be using suppliers to

3

help finance operations. As shown Ryland has improved in this area bringing the ratio down to 5%.

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Conclusion: Ryland's inventory appears excessive. They

3

need to sell homes to bring the level down. I see no

* problems in their collections and their accounts payable to sales appear adequate.

Profit planning

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PROFITABILITY RATIOS

3

Test/Year 1991 1992 1993

Sales Volume $863 Mill $1078 Mill $1203 Mill

Net Profit 2.1% 2.6% 0%

3

Margin Return on 0.50% 0.95% 0%

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Assets

3

Return on Net 8.14% 9.0% 0% Worth

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a) Ryland's sales volume continues to increase

b) The profit margin is low and the company had a net loss

3

in 1993. The company states this loss was primarily due to

5

the third quarter pretax provision of $45 million in reserves for homebuilding inventories and investment in

I

unconsolidated joint ventures.

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c) Return on assets is the key indicator of profitabilicy for a firm. Companies efficiently using their assets will have a relatively high return while less well-run businesses will be relatively low.

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d) Return on net worth is used to analyze the ability of the firm's management to realize an adequate return on the capital invested by the owners.

Conclusion: Ryland has continued to increase its revenues but its net profit margin, returns on sales, assets and net worth as of 1993 shows no return. The company must become

* more efficient in its operations in addition to increasing

3

sales to turn these numbers around.

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Profit Center Analysis

The following information breaks Ryland's revenue and profits into company segments.

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Company Segment Revenue

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_(Millions of dollars) 1991 % 1992 1993 Home Bldg. $859 71 $1,077 75 $1,204 82 Financial $74 6 $142 10 $160 11 Services Limited- $277 23 $223 15 $110 7 purpose subsidiaries

3

Total Revenue $1,210 100 $1,442 100 $1,474 100

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This chart shows that home-building continues to provide the

3

majority of the revenues to Ryland. It also shows a slight increase of revenue provided by financial services and the continuous decrease of revenues from the Limited-purpose

3

isubsidiaries. The company states this decrease of revenue

3

in this segment is due to changes in the tax laws for the sale of its mortgage-backed securities.

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Company Segment Pre-tax Earnings

(Millions of dollars)

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1991 1992 1993

3

Home Bldg. $(3.3) $11.0 $(45.9) Financial $26.9 $43.9 $55.3

3

Services Limited-purpose $2.3 $3.9 $0.2

3

subsidiaries Corporate $(11.6) $(16.5) $(14.2)

3

Total Earnings $14.30 $42.30 $(4.60)

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This chart shows the company financial services continues to i be the bread winner of the company. The home building

segment had poor performances both in 1991 and 1993. While the limited-purpose subsidiaries contributes to the bottom

3

Iline less each year. The loss shown for Coporate is the

3

company's Fixed Overhead costs.

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Homebuilding Seament

5

Markets: In Jan. 1994 to address the distinct characteristics of the California market and the

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opportunities available there, the company elected to form a California Region, comprised of the Los Angeles, Sacramento and San Diego markets.

The company's operations in each of its homebuilding

3

markets differ based on a number of market-specific factors.

3

These factors include regional economic conditions and home growth, land availability and the local land development

I

process, consumer tastes, competition from other builders of

5

new homes and home resale activity. The company considers

each of these factors when entering into new markets or determining the extent of the operations in existing

3

markets. In 1993, the company entered into the Austin and

5

San Antonio, Texas markets through its acquisition of an

interest in a joint venture with Scott Felder Homes. The

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company also entered into the Chicago market during the

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Land Purchases: The company continuously seeks and acquires land for replacement and expansion of land

inventory within its current markets and for expansion into new markets.

* Material Costs: To increase purchasing efficiencies,

3

the company uses standardized building materials and products in its homes. In addition, the company operates

i

plants in Maryland, North Carolina, Ohio, and Texas that

3

produce and ship rough lumber packages and trim materials to

building sites. The company utilizes these plants to control production, improve on-site building times and

* control the cost and quality of materials.

3

Marketing: The company normally commences construction of homes when a customer has selected a lot and model and has received preliminary mortgage approval. However,

3

Iconstruction of homes may begin prior to a sale to satisfy market demand for completed homes and to ease construction

scheduling.

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Financial Services Segment

In 1993, the mortgage refinancing boom propelled Ryland

I

Mortgage to its third consecutive year of record profits.

I

To compensate for the expected decline in refinancing during 1994, the company plans to increase the number of loans

originated by expanding spot loan activity and by earning a greater percentage of business from Ryland homebuyers.

I

They plan on accomplishing this through a convenient mortgage process, high level of service and competitive

rates. The company introduced the 5-minute Mortgage in

I

1993. This is pre-approval information available within 5

* minutes.

The company is also expanding into new markets,

providing opportunity to increase earnings power and market

* presence.

By building on its expertise in originating mortgages and selling them in the secondary market, Ryland Mortgage

* has become one of the Nation's leading issuers and administrators of mortgage-backed securities.

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Cc i _{Ryland has undergone a year of transition. The}

3

company changed management and its strategies in the

homebuilding segment. In the third quarter the company made

I

a $45 million pretax provision for homebuilding inventories.

*57

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This resulted from a decision to initiate a change in strategy in the California and Mid-Atlantic Regions by accelerating the completion of and withdrawal from higher-end communities negatively impacted by economic conditions

I

experienced during 1993. Although this contributed to the

company's net loss in 1993, this final writedown will enable the company at a minimum to breakeven next year.

I

The company's financial services has been a stellar performer. The expansion of this segment and optimizing within will add additional profits to the company.

With the declining profits provided by the

Limited-I

Purpose subsidiaries, the company should consider

I

dismantling this segment of the company.

I

The following page shows a comparison of Net Profit Margins of Ryland and two of its competitors. Ryland's $45 million pretax provision in 1993 is obvious in this graph.

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HOVINEDMI~CI

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5.2 Morrison Knudson Corporation

Business: Morrison Knudson Corporation operates in

two industry segments: engineering and construction, and

rail systems. The engineering and construction segment provides design, engineering, construction, procurement,

3

project-management and construction-management services in the infrastructure market, including transportation, water

I

resources, heavy civil and energy developments, as well as

3

industrial, institutional and commercial buildings. The segment also provides skills for the nuclear and fossil-fueled power markets and in cogeneration, waste-to-energy,

3

environmental and hazardous waste, and wastewater treatment

3

fields; and in addition serves the hydroelectric, toxic waste, oil and gas, and mine engineering markets. A number

I

of domestic subsidiaries are engaged in long-term contract

mining of coal and lignite at mines in the United States.

Other markets include operations and maintenance services

for military and commercial facilities.

3

The rail systems segment is engaged principally in

3

building new and rebuilding used mass transit rail cars in New York, California, Illinois and Buenos Aires, Argentina

I

and rebuilding railroad loccmotives at Boise, Idaho,

3

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Pennsylvania and South Australia and, in addition, provides aircraft service and maintenance to private and commercial aircraft at Boise, Idaho.

In addition, the Corporation has equity interests in a U.S. development-stage, high-speed commuter rail company, a

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gold mining company, Indonesian prestress concrete

manufacturing and construction companies, a mining company

I

that operates a surface coal mine in Montana, a company to

3

design, build and operate a toll bridge in Canada and a company that operates and maintains commuter railways in Buenos Aires, Argentina.

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Financial Analysis

Because of MK's large diversification, an acceptable limit on the ratios was not found. However, looking year to

3

year we are able to analyze general trends.

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LIQUIDITY RATIOS Test/Year 1991 1992 1993

3

Acid Test _{1.03 0.56 0.47} Current Ratio 1.72 1.12 1.15

I

Debt/Equity 2.93 3.14 ratio

3

Current 97% 163% 156% Liab/Net Worth

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a) The acid test shows the number of dollars of liquid

assets available to cover each dollar of current debt.

Anytime this ratio is as much as 1 to 1 the business is said

3

to be in a liquid condition. The larger the ratio the

3

greater the liquidity. As shown above, MK is becoming less

liquid each year.

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b) The current ratio measures the degree to which current

3

assets cover current liabilities. The higher the ratio the

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more assurance exists that the retirement of current

liabilities can be made. As shown MK had a large drop from 1991 to 1992.

c) Debt to equity ratio shows as of 1993 creditors funding

i

is over 3 times that of the owners equity. This may be

3

excessive, especially if the company is burdened with

substantial interest charges.

d) The current liabilities to net worth ratio shows a large

3

increase from 1991. The smaller the net worth and the

p

larger the liabilities, the less security for the creditors.

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Conclusion: It is obvious from the above ratios that MK is

3

carrying a large portion of debt. With the construction

industry being cyclical, an upturn in this industi-y should have a significant impact on lowering MK's debt commitments.

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Cash Analysis

EFFICIENCY RATIOS

Test/Yr 1991 1992 1993

Avg age of Accts 23.4 days 25.6 days 31.0 days Receivable

Sales to Inventory 39.3 29.0 20.4

Accounts Payable 12W 14% 11%

to Sales

a) The company's average age of receivables has increased year to year, however it is well within the recommended 45

5

day period.

b) The sales to inventory ratio is a guide to the rapidity at which inventory is being moved and the effect on the flow of funds into the business. Inventory control is a prime management objective since poor controls allow inventory to become costly to store, obsolete or insufficient to meet

demands. As shown, the ratio has decreased recently indicating addition inventory or slower moving inventory. This may be the result of MK's commitment to purchase its suppliers, expanding its business and the recent recession. c) Accounts payable to sales measures how the company is paying its suppliers in relation to the volume being

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transacted. An increasing percentage or one larger than the

3

industry norm, indicates the firm may be using suppliers to help finance operations. As shown MK has improved in this area bringing the ratio down to 11%.

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* Conclusion: MK is collecting from its customers in a timely manner. Inventory turnover has increased, however this may be due to expansion within and the economic recession. The

3:

company has also improved on its payments to creditors. I believe MK is doing the right things to efficie•.-ly use its

cash.

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Profit planning

PROFITABILITY RATIOS

Test/Year 1991 1992 1993

Sales Volume $1,980 Mill $2,285 Mill $2,723 Mill

Net Profit 1.6% 0.6% 1.0% Margin Return on 2.93% 1.38% 3.70% Assets Return on Net 8.0% 3.57% 6.95% Worth

a) MK's sales volume continues to increase

b) The profit margin is low and took a dip in 1992. It 65

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picked up in 1993 and should continue to improve as the

3

economy recovers. Net Profit Margin reveals the profits earned per dollar of sales and therefore measures the

efficiency of the operation. This ratio is an indicator -)f

3

the firm's ability to withstand adverse conditions such as i falling prices , _{rising costs and declining sales.}

c) Return on assets is the key indicator of profitability

I

for a firm. Companies efficiently using their assets will

3

have a relatively high return while less well-run businesses

will be relatively low.

d) Return on net worth is used to analyze the ability of the firm's management to realize an adequate return on the

3

capital invested by the owners.

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Conclusior.: MK has continued to increase its revenues but

£

its net profit margin, returns on sales, assets and net

worth have not performed that well. 1993 showed a